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Clean Diesel Technologies, Inc. (NASDAQ:CDTI)

Q1 2014 Earnings Conference Call

May 08, 2014 11:00 AM ET

Executives

Nikhil A. Mehta – Office of the Chief Executive Officer and Chief Financial Officer

Pedro J. Lopez-Baldrich – Office of the Chief Executive Officer, General Counsel, Corporate Secretary and Vice President of Administration Analysts

Analysts

Matt B. Koranda – ROTH Capital Partners LLC

Ian T. Gilson – Zacks Investment Research, Inc.

Operator

Good day ladies and gentlemen and welcome to the Clean Diesel Technologies, Inc. First Quarter 2014 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instruction) As a reminder this conference call is being recorded. I would now like to introduce your host for today’s conference, Pedro J. Lopez Baldrich, Member of the Office of the CEO and General Counsel. Sir, you may begin.

Pedro J. Lopez-Baldrich

Thank you. Good morning and thanks to everyone for joining us. By now, you should have the copy of our results press release, which crossed the wire this morning prior to market open. A copy of the press release, along with other company information may be found on the Investor Relations page of our website www.cdti.com.

Before I turn the call over to Nikhil Mehta, Member of the Office of the CEO and Chief Financial Officer of CDTI, I want to emphasize that some of the information you will hear during our discussion today will consist of forward-looking statements that are predictions, projections and other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties.

Actual results could materially differ because of factors discussed in today’s results press release and the comments made during this conference call, and in the Risk Factor section of our Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any obligation to update any forward-looking statements.

I’d like now to turn the call over to Nikhil Mehta.

Nikhil A. Mehta

Thank you, Pedro and good morning everyone. I will start with the summary of our first quarter, including some brief comments on each of our business divisions and an update on our strategic priorities. We will then open the call to your questions. Our first quarter operating results were largely consistent with the expectations we shared with you in our year end 2013 conference call.

We experienced modestly lower sales in our Catalyst division, primarily due to lower, rare earth reimbursements and a decrease in sale of service parts. We continue to expand our footprint within our major OEM customer Honda to other platform models.

In March, we were very pleased to announce that we had begun production of Catalyst featuring our high performance Mixed Phase Catalyst technology for Honda’s 2015 Acura TLX model, and we expect shippings to commence in the first half of 2014. Along with the Acura TLX, we also provide our catalyst solution to Honda for North American versions of their four and six cylinder Accord, Acura RLX as well as hybrid and plug-in hybrid models.

Our Heavy Duty Diesel Systems or HDD division sales were essentially flat for the quarter as retrofit activity in the U.S., excluding California and our European mining and material handling business continued to experience soft conditions.

And the bright spot for the HDD business has been the continued momentum in retrofit sales in California with sales increasing nearly 60%, compared to last year. As previously disclosed, the California Air Resources Board or CARB, extended the deadline for compliance under the truck and bus rule from January 1, 2014 to July 1, 2014 which is expected to result in greater retrofit activity in the State, in the second quarter.

Beyond California, we do see increased funding and continued retrofit potential in other states, including New Jersey, New York, Massachusetts, Illinois and Texas, amongst other states as additional federal funding from the U.S. Department of Transportations, Congestion, Mitigation and Air Quality improvement program or CMAQ as well as various other state and local programs are moving ahead.

Gross margin was another highlight for the quarter as both divisions reported increases in our overall gross margin. And our margin was up 7.6 percentage points year-over-year. Total operating expenses in the first quarter were up modestly from the prior year period. However, they would have been down on a comparable basis, after excluding a charge for severance and other expenses. While we have made significant progress and we continue our efforts to lower our costs going forward, we are making additional investments in our advanced low PGM and zero-PGM or ZPGM technology, as we prepare to capitalize on opportunities for top line growth driven by increasingly stringent emission regulations.

During the first quarter, we filed four new patents pertaining to our unique ZPGM and advanced low PGM Catalyst technology. We are also increasing our investments to develop and qualify emission catalysts in order to support our OEM customers, as we seek to expand our Catalyst technology to other vehicle platforms.

The fund raise of approximately $6.1 million that we completed in early April enabled these investments. We remain keenly focused in pursuing development of our Materials Science Platform and capitalizing on the opportunities ahead.

Now I will share some specific comments on our first quarter. Revenue of $12.5 million was down 6.4% compared to last year. Gross margin was 31% compared to 23.4% in the prior year period of more than 700 basis points. Total operating expenses for the first quarter of 2014 were $5.3 million compared to $5.1 million in the prior year quarter.

First quarter expenses included a charge of approximately $400,000 for severance and other expenses including a non-cash charge of approximately $200,000 or $0.02 per share related to shares issued in connection with the previously announced settlement agreement with a former company executive.

With the significant improvement in gross margins and the continued focus on expense control, loss from operations narrowed to $1.4 million compared to a loss of $2 million for the prior year period despite the modest decline in sales.

Our other expense for the quarter includes a non-cash charge of $2.1 million or $0.21 per share resulting from an increase in the estimated fair value of the liability associated with issued warrants. The increase in the estimated fair value of this warrant liability was primarily related to the increase in the company stock price in the first quarter of 2014.

Net loss for the quarter, which includes the non-cash charges of $2.3 million or $0.23 per share that I just discussed was $3.8 million or $0.39 per share versus a net loss of $2.1 million or $0.29 per share last year.

We had $3.6 million of cash as of March 31, 2014 and not included in that amount are the net proceeds from our April 2014 offering in which we received approximately $6.1 million. Moving on to the operating divisions, I would highlight the performance in the first quarter.

Our external Catalyst division OEM sales of $5.3 million reflect a decrease of approximately $700,000 compared to last year’s sales. The decrease was a result of lower rare earth prices, which are passed through to the customer as well as a decrease in the sale of service part.

Reported gross margin was up nearly 7% percentage points year-over-year to more than 26% for the quarter. Gross margin improved due to a favorable product mix resulting from an expansion of models sold to Honda, lower cost of certain raw materials, improved manufacturing efficiency and improved margins on the sales to the HDD division. This division generated an operating profit of approximately $200,000 for the quarter compared to a profit of approximately $100,000 last year. Our HDD Systems division sales of $7.2 million were down 1.7% from $7.3 million last year. Sales increased under the California retrofit program.

However as mentioned earlier, sales were down in North American retrofit activities in the 49 states, excluding California and we continued to experience soft conditions in our mining and material handling business in Europe.

We recorded approximately $4.2 million of sales under the California retrofit program, which was up significantly compared to the prior year quarter. Expanding our HDD Systems division sales from non-retrofit sources for the reduction of emission in exhaust emission continues to be an area of focus for us as they represent a more sustainable OEM and after-market business.

One area within the non-retrofit market that we are now actively pursuing is the emerging after-market for replacement filters in North America for both heavy duty and medium duty diesel vehicles. We expect to leverage our existing technology and know-how to cost effectively serve this emerging market and would expect to see some activity in the second half of 2014 and building from there in the ensuing years.

Lastly, in spite of the weakness in the mining and material handling sectors, we still see opportunities for growth within our HDD OEM customers. Gross margin in the HDD Systems business increased nearly 8 percentage points year-over-year to more than 33% in the first quarter. Gross margins improved as a result of improved manufacturing efficiency, low raw material costs and to favorable product mix.

The HDD division reported an operating profit of approximately $300,000 in the quarter compared to an operating loss of approximately $300,000 last year. So to summarize, the positives for the quarter included; one, our strong operating performance and product mix help drive impressive gross margin expansion; two, we narrowed our net operating loss from a year ago, which is encouraging; three, we reported solid revenue growth in the California retrofit market; and finally, we continued to expand our IP portfolio.

In conclusion, the first quarter was largely consistent with our expectations. We are encouraged by the opportunities we see across our end markets as we move through 2014 giving us optimism about our ability to deliver improved performance going forward.

This concludes my prepared remarks this morning. I would now like to open the call for questions. Operator, we are now ready for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from the line of Matt Koranda from ROTH Capital. Your line is now open.

Matt B. Koranda – ROTH Capital Partners LLC

Good morning, Nikhil. Thanks for taking my questions. Just wanted to start out on the gross margin piece here. You guys have posted some nice gross margins over the past quarter and continuing into Q1. Is this sort of the normal run rate you think that we could consider going forward? How do you think about gross margins as we move through the year?

Nikhil A. Mehta

Matt, as you know, we don’t give guidance, but we are feeling good about stringing together few quarters of good margins. I would say that this level is sustainable, but it’s so heavily dependent on product mix that I can’t really say exactly what kind of margin we’d see going forward. But in terms of manufacturing efficiencies, lower raw material prices, those are real.

Matt B. Koranda – ROTH Capital Partners LLC

Okay. That’s still helpful. And in terms of Honda, is Honda looking at you guys for additional platforms? You guys had the nice win with Acura a few months back. And then may be just higher level, what is it about Honda where they can get comfortable sourcing from CDTI, but other OEMs are taking kind of longer? Is it just a function as they know your technology and they’re used to it and the Accord or is it something different about the way that they procure?

Nikhil A. Mehta

That’s a great question, Matt. Well, as you know, we’ve had a very, very long relationship with Honda. We’ve been supplying to Honda for over a decade now. Obviously, they certainly feel that our technology is something that gives them a lot of benefits and they continue to do business because of that. And as you can see that we have been significantly or at least we’ve been adding several vehicle platforms to our business in Honda, especially over the last 12 or 18 months or so. And we continue to work with them. They like us. We have a very close relationship with them and it’s our technology. What else can I say?

Matt B. Koranda – ROTH Capital Partners LLC

Okay. That’s fair. And then, let’s just move on to the HDD for a moment here. Now that we’re just over a month in the Q2 and given the expectations you shared that the retrofit market in California should experience a ramp. Can you just comment in general about the market activity that you guys are seeing, how are things expanding during the quarter? Any color on that would be appreciated.

Nikhil A. Mehta

We’re still optimistic that there will be a ramp in the California market in the second quarter because of the deadline. There was a meeting at CARB late in April where the Board heard some objections from certain segments of the trucking industry, but the results for that meeting have not really significantly changed anything. So we do wish for the truckers to become compliant by the end of this quarter.

Matt B. Koranda – ROTH Capital Partners LLC

Okay. And then, could we just do – I don’t know if it’s maybe too early, but could you do sort of as post-mortem on the California retrofit market now that it’s sort of starting to wind down here? What have you guys learned and how do you plan on applying it to future potential retrofit markets, maybe in the other states in the U.S. here?

Nikhil A. Mehta

Okay. So that’s a very good question too. Again, you got to realize that the California retrofit program was very different from what we are doing in some of the other states. Namely in all the other states the retrofit programs that we are going after are funded by either the federal government or the state government or some kind of state funding.

This was a program the first of its kind in North America where a state was actually mandating private fleets to retrofit their vehicles or to make their vehicles compliant. And when you’re in a – hate to use the word, but it’s a more commercial environment than in other states. You are dealing with a whole set of other factors. And so what we learned was that vehicle fleets and vehicle owners while they’re trying to be complaint do have different ways of doing it. Large fleets can move fleets around between states.

Smaller vehicle owners have delayed compliance as much as possible. There have been lot of industry groups from the trucking industry that have complained about the regulations and delay. So there is a whole lot of other factors that have resulted in the California program. While it’s been very lucrative it has resulted in, if I’m right, close to $12 million, $13 million of sales a year for the last two years and we did $4 million in the first quarter of this year.

It wasn’t as big as CARB had originally projected. For some of these reasons the truckers were able to do certain things that did not require retrofit and things like shopping out vehicles and the like. So, again, your question about how do we translate this to other states is very different than the other states that have very specific government-funded programs such as school districts or municipal programs and the like and that’s a different kind of dynamic. I hope that rambling answer kind of answered your question.

Matt B. Koranda – ROTH Capital Partners LLC

Yes, that was actually really helpful, Nikhil. And I’ll jump back in queue. Thanks a lot.

Operator

Thank you (Operator Instructions) And our next question comes from the line of Ian Gilson of Zacks Investments. Your line is now open.

Ian T. Gilson – Zacks Investment Research, Inc.

Hello, good morning.

Nikhil A. Mehta

Hi, Ian.

Ian T. Gilson – Zacks Investment Research, Inc.

Can you repeat? You sort of raised to right buy the California number because you were paid that and also give us last year number as well.

Nikhil A. Mehta

Okay. So we did $4.2 million of sales in California in the first quarter and that believe last year’s number was $2.5 million or thereabout in the first quarter.

Ian T. Gilson – Zacks Investment Research, Inc.

Okay, okay. The elimination charge, which is to transfer from catalyst to HDD, correct?

Nikhil A. Mehta

Yes.

Ian T. Gilson – Zacks Investment Research, Inc.

Increased?

Nikhil A. Mehta

Yes.

Ian T. Gilson – Zacks Investment Research, Inc.

Catalyst sales declined?

Nikhil A. Mehta

Right

Ian T. Gilson – Zacks Investment Research, Inc.

Can you sort of run through why they moved in different directions?

Nikhil A. Mehta

Okay. So I did say in my remarks that catalyst sales to outside customers declined by about $700,000 and some of that was related to rare earth pricing coming down from last year. As you know, we get dollar for dollar reimbursement for rare earth in our catalyst from Honda and as those prices come down they had no impact on the gross profit, but the revenue comes down. And then we had, I would say, a slightly unusually high level of service part sales in the first quarter last year and this year we were more at the normal level. We sell service parts to customers we supplied in the past such as General Motors and Renault.

Ian T. Gilson – Zacks Investment Research, Inc.

Okay. So basically the rare earth’s pass-through charge is sort of exclusive to the Honda contract?

Nikhil A. Mehta

Yes.

Ian T. Gilson – Zacks Investment Research, Inc.

Okay. I’m not all that familiar with how Honda sources. Are all of their reported monthly sales from U.S. deduction or do they import the Accord as well as from other countries?

Nikhil A. Mehta

I believe if look at their Accord and Acura sales that they report every month, I believe, they’re all U.S. I think now they’re all U.S. sourced, but there was a piece of the Accord that used to be sourced out of Japan. I believe it’s now all U.S. sourced.

Ian T. Gilson – Zacks Investment Research, Inc.

Okay, okay. And tell what takes the place of the CARB deadlines, do we see California drop like the London Low Emission Zone revenue did?

Nikhil A. Mehta

I don’t think it’s going to be that kind of a drop because there are still – remember the program originally was going through 2016 and that’s still true. There’s still a fair number of vehicles that are out there, but given they are going to build for because of the size of the businesses and all that. Their deadlines are strand out over the two or three years. So it’s not going to be the kind of drop that we saw because London was a one-time shot, which lasted literally two quarters. This thing will start declining and it will take maybe through next year before it completely goes away.

Ian T. Gilson – Zacks Investment Research, Inc.

Okay, okay, fine. Thank you very much. And let me see, let me one last sort of question on the warrant devaluation. As we see the price of the stock go up, is that number always going to go up?

Nikhil A. Mehta

Yes. Yes, just to be very clear. We had issued warrants last summer at a strike price of $1.25. About 800,000 of those warrants have been exercised. Most of the warrant liability change this year that 2.1 million was associated with those warrants. Now in the April fund raise, we issued another 800,000 warrants as a strike price of $4.20. Those also will be classified as a liability warrant and depending on the stock price are going up or down we’ll picking up gains or losses every quarter.

Ian T. Gilson – Zacks Investment Research, Inc.

Probably as they’re exercised or…?

Nikhil A. Mehta

No.

Ian T. Gilson – Zacks Investment Research, Inc.

This is clearly a place of…

Nikhil A. Mehta

We have to value those warrants every quarter. We’ve been doing that every quarter. It’s not been noticeable because until January, February, March this year, our stock price was sort of stable last year. It wasn’t as volatile as it had been in the past. So you didn’t see the big impacts that you saw because in the first quarter, as you know, our stock price went from $1.50 in December all the way up to $7 and then back down to $3.80 in March. So that’s kind of volatility unfortunately because the way U.S. GAAP requires us to record liability warrants, it will have this fluctuating impact on our other income and expense.

Ian T. Gilson – Zacks Investment Research, Inc.

Okay. Is it based on the quarter end price or an average price of the quarter?

Nikhil A. Mehta

It’s based on the quarter end price.

Ian T. Gilson – Zacks Investment Research, Inc.

Okay, great. Thank you very much.

Operator

Thank you. And I’m showing no further questions at this time. I would now like to turn the call back to Mr. Mehta for any further remarks.

Nikhil A. Mehta

Well, thank you all for being at our call today and we look forward to our next quarter’s earnings call. Thank you all.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Have a great day everyone.

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